Economic growth and GDP

Economic growth = an increase in real GDP (short-run: actual growth, using up spare capacity) or an increase in productive potential (long-run: LRAS/PPC shifting out).

• Nominal GDP is measured at current prices — it rises with inflation even if nothing more is produced. Real GDP is adjusted for inflation and is the only meaningful measure of output.
• GDP per capita = GDP ÷ population. This is what matters for living standards: if GDP grows 2% while population grows 3%, people are on average getting poorer.

Benefits of growth: higher incomes and living standards; lower unemployment; higher tax revenue (funding public services without raising rates); rising profits and investment; reduced absolute poverty. Costs: inflation risk; a widening current account deficit; inequality if the gains are concentrated; negative externalities — pollution, congestion, resource depletion; and the erosion of non-material wellbeing (long hours, stress).

Your turn — the growth rate

Inflation, index numbers and real values

Inflation = a sustained rise in the general price level. It is measured by the Consumer Prices Index (CPI): a "basket" of around 700 goods weighted by household spending patterns, re-priced monthly. The Bank of England's target is 2% CPI (with a ±1pp band).

• Deflation — a sustained FALL in the price level (negative inflation). Demand-side (malign) deflation is dangerous: consumers delay purchases waiting for lower prices, so AD falls further; the real value of debt rises, crushing borrowers (debt deflation); and nominal interest rates cannot fall below roughly zero, so monetary policy runs out of road. Japan's lost decades are the case study.
• Disinflation — inflation is still positive but the rate is falling (e.g. from 6% to 3%). Prices are still rising, just more slowly.
• Hyperinflation — extremely rapid inflation which destroys money's function as a store of value and a unit of account (Weimar Germany, Zimbabwe).

Causes: demand-pull (AD shifts right faster than AS) and cost-push (SRAS shifts left: oil, wages, import prices after a depreciation, taxes). Also the monetarist view (Fisher's MV = PQ): if the money supply grows faster than output, prices rise.

Costs of inflation: it erodes the real value of savings and of fixed incomes; it damages international competitiveness if it exceeds rivals' inflation; menu costs and shoe-leather costs; fiscal drag; uncertainty deters investment; and it redistributes arbitrarily from lenders and savers to borrowers.

Real vs nominal — a distinction that carries marks in every macro paper:

Your turn — inflation from an index

Your turn — real wages

Deflation or disinflation?

Employment and unemployment

Unemployment = those of working age who are willing and able to work, actively seeking work, but without a job. Two UK measures:

• Labour Force Survey (LFS) — the internationally comparable ILO measure, based on a large survey. It is the broader and more accurate figure.
• Claimant Count — those actually claiming unemployment-related benefits. It is cheap and instantly available, but it understates true unemployment (many jobless people do not or cannot claim) and it changes whenever the eligibility rules change.

Types of unemployment:

• Cyclical (demand-deficient) — caused by a fall in AD in a recession. The type that fiscal/monetary stimulus can cure.
• Structural — a long-term mismatch between the skills workers have and the jobs available (deindustrialisation, automation). Made worse by occupational and geographical immobility. Cured only by supply-side policy: retraining, relocation support, education.
• Frictional — short-term, between jobs. Always present, and not necessarily bad — it reflects people searching for a good match.
• Seasonal — predictable, time-of-year unemployment (tourism, agriculture).
• Real-wage (classical) — wages held above the market-clearing level (by unions or a minimum wage), creating excess supply of labour.

Costs: to the individual — lost income, deskilling, poorer physical and mental health; to the government — higher benefit spending and lost tax revenue, worsening the deficit; to society — lost output (a negative output gap), higher crime, deprivation, and long-run hysteresis shifting LRAS left. Full employment does not mean zero unemployment — frictional and some structural unemployment always remain.

Which type of unemployment?

The balance of payments and the current account

The balance of payments records all transactions between UK residents and the rest of the world. The current account has four components:

• Trade in goods — visible exports minus imports (the UK runs a large deficit here).
• Trade in services — finance, insurance, education, tourism (the UK runs a surplus).
• Primary income — interest, profit and dividends earned on overseas assets, minus those paid out.
• Secondary income — transfers with no goods in return (foreign aid, remittances, EU-type contributions).

Causes of a deficit: poor price competitiveness (high relative inflation, an overvalued exchange rate, high unit labour costs); poor non-price competitiveness (quality, design, reliability); strong domestic growth sucking in imports; structural decline in manufacturing.

Consequences: a deficit is not automatically bad — it means the country is consuming more than it produces, financed by capital inflows, and if that capital funds productive investment it can be entirely sustainable. But a large, persistent deficit means growing external liabilities, vulnerability to a sudden stop in capital inflows, downward pressure on the currency, and a drag on AD (imports are a leakage).

Your turn — the current account

The Phillips curve and policy conflicts

In 1958 A.W. Phillips found an apparently stable inverse relationship between unemployment and wage inflation. The short-run Phillips curve (SRPC) says there is a trade-off: cut unemployment by boosting AD, and you get more inflation; squeeze inflation, and unemployment rises.

The 1970s destroyed the simple version: stagflation delivered high inflation AND high unemployment simultaneously. Friedman and Phelps had already explained why:

• Workers care about real wages. A boost to AD only cuts unemployment because workers are temporarily fooled — they mistake a nominal pay rise for a real one and supply more labour.
• Once they realise prices have risen too, they demand higher nominal wages to restore their real wage. Employment falls back to where it started — but at a higher inflation rate. The SRPC has shifted up.
• So in the long run there is NO trade-off: the long-run Phillips curve (LRPC) is VERTICAL at the natural rate of unemployment — the NAIRU (non-accelerating inflation rate of unemployment).

The NAIRU is the unemployment that remains when the labour market is in equilibrium: frictional plus structural. Push unemployment below the NAIRU and inflation accelerates. The only way to reduce unemployment permanently is to shift the NAIRU itself to the left — and that requires supply-side policy (retraining, better job matching, labour market flexibility, improved mobility), not demand management.

The other policy conflicts:

• Growth vs inflation — rapid AD-led growth causes demand-pull inflation.
• Growth vs the current account — growth sucks in imports, widening the deficit.
• Growth vs the environment — more output means more emissions and resource depletion unless growth is decoupled.
• Unemployment vs inflation — the Phillips trade-off (short run).
• Equity vs efficiency — higher taxes and benefits reduce inequality but may blunt incentives to work, save and take risks.
• Reducing the deficit vs growth — austerity cuts AD, and the reverse multiplier can shrink the tax base by more than the savings.

The prize: a rightward shift of LRAS raises output and lowers the price level at once. It is the only policy that resolves the growth-inflation conflict rather than trading one off against the other — which is why every government claims to be doing supply-side reform.

The long-run Phillips curve

Policy conflict

Reducing the NAIRU

GDP per capita

Which type of unemployment?

Tap a case, then tap the type of unemployment it illustrates.

Match the inflation term to its meaning

Tap an item on the left, then its partner on the right.

The big ideas to know

You've now covered economic policy objectives and their conflicts from the OCR A-level Economics (H460) specification. Press Finish to see your score.